Summary:

On December 2nd, the yield on 10-year government bonds fell below 2%, reaching a 22-year lowBoth offshore and onshore renminbi experienced significant depreciation, setting new four-month lowsThis raises the question: why did both bond yields and the renminbi depreciate in unison on the first trading day of December? While the short-term depreciation of the renminbi may be limited, medium to long-term downward pressure on the currency is considerable.

1. On Monday, the yield on 10-year government bonds falls below 2%, hitting a 22-year low.

On Monday, December 2nd, there were significant fluctuations in the bond market

In the late afternoon, the benchmark yield for 10-year government bonds dropped to 1.981%, falling sharply by 3.96 basis points from the previous trading day, marking the lowest level since April 2002.

The rate of 2% is a crucial psychological threshold for the 10-year government bonds, with a breach of this level being as significant as the Shanghai Composite Index falling below 3000 points for the bond market.

At the same time, the one-year government bond yield fell from 1.368% to 1.35%, dropping by 1.98 basis points; the 30-year bond yield also decreased from 2.2025% to 2.17%, with a decline of 14.5 basis points.

2. Offshore and onshore renminbi plunge, reaching four-month lows.

Since October, the dollar index has maintained high volatility, putting continuous pressure on the renminbi exchange rate

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By the end of October, the renminbi had depreciated by 1.4% against the dollar since the end of September to 7.1178, and in November, it fell a further 1.72% to 7.2423.

On December 2nd, during the first trading day in the foreign exchange market, the renminbi against the dollar broke below the 7.25 and 7.26 marks, hitting a minimum of 7.2741, the lowest level since July 25. By 6 PM, it closed at 7.2735, down by 312 points, a significant decline of 0.43%.

On Monday, the offshore renminbi showed more volatility compared to the onshore currencyIt pierced through the marks of 7.27, 7.28, and 7.29 within a single day, reaching a minimum of 7.2957, also a four-month low.

As of 6 PM, the offshore renminbi to dollar exchange rate fell by 479 points to 7.2951, marking a substantial drop of 0.66% from the previous trading day.

3. Why did both bond yields and renminbi exchange rates drop on the first trading day of December?

Readers familiar with this analysis know that examining the exchange rate between the renminbi and the US dollar begins with evaluating the yield difference between the two countries' ten-year government bonds

The bond yields reflect market expectations regarding interest rates; an expansion of this yield gap signifies a depreciation in the renminbi and an appreciation of the dollar.

Despite the significant interest rate cuts of 50 basis points in September and 25 basis points in November by the Federal Reserve, the current yield on Chinese ten-year government bonds is still less than half of the US government bonds.

On Monday, the yield on Chinese 10-year government bonds fell below 2% to 1.981%, widening the yield differential with the US's yield of 4.18% from 1.55 percentage points in mid-September to 2.2 percentage points currentlyThe offshore renminbi has also depreciated from 7.06 in mid-September to 7.2951 on December 2, marking a 3.22% decline.

How is it that China’s interest rate cuts are less significant than America’s, yet the bond yields in China have dropped more sharply? This disparity is primarily due to the unexpectedly robust economic performance in the US recently, highlighted by strong personal consumption, persistent inflation, and impressive stock market results.

Conversely, China's economy is experiencing a slowdown, following a lack of appealing investment options, leading to a flood of investments into the bond market as a safe harbor asset

The central bank attempted to adjust long-end interest rates through reverse repo operations in August and September, aimed at preventing bond trading prices from rising perpetually and yields from decliningThe People's Bank of China repeatedly warned investors that a bubble in the bond market could destabilize financial markets.

However, these actions only influence market trends in the short term, with a quick reversion to pre-intervention patterns typically within one to two weeksThis can be attributed to several underlying factors:

First, the favorable liquidity combined with an ongoing weak economic backdrop creates a pronounced anticipation of further interest rate cuts, fueling the upward trend in bond trading prices and the corresponding decline in yields.

Before the substantial drop in bond yields on Monday, the People’s Bank of China announced that it injected 800 billion yuan into the banking system through direct reverse repos on November 29. This marked a 60% increase over the 500 billion yuan injection conducted in October.

The central bank introduced the direct reverse repo tool in its open market operations on October 28 to diversify its monetary policy toolkit

Just three days later, the central bank executed its first such operation, injecting 500 billion yuan into the market.

Second, the People’s Bank of China announced a net purchase of 200 billion yuan in government bonds in November.

On November 29, the People’s Bank of China also revealed that it had conducted net purchases of 200 billion yuan of bonds in its open market operations to enhance its counter-cyclical monetary policy adjustments and maintain reasonable liquidity within the banking system.

PBOC Governor Pan Gongsheng indicated earlier in November that efforts to strengthen monetary policy's counter-cyclical adjustment aim to create a favorable monetary and financial environment for stable growth and high-quality development, having net purchased government bonds valued at 100 billion, 200 billion, and 200 billion yuan in August, September, and October, respectively.

The rationale for the central bank's net bond purchases is to reinforce monetary policy efforts, signaling clear support for economic growth and domestic demand expansion.

Third, the reduction in deposit rates has signaled the market that loan rates will likely be lowered further.

In November, major state-owned banks began to lower their deposit rates, intensifying expectations for a monetary policy further easing to stimulate the struggling macro economy.

Simultaneously, the People’s Bank of China has been insisting that deposit rates offered by banks to investment firms and other non-bank financial institutions must align with policy rates

Given the substantial and stable deposits held by non-bank financial institutions, commercial banks had previously offered higher preferential rates to attract these fundsThe central bank's policies, however, have undoubtedly reduced average short-term deposit rates, opening the doorway for further loan rate reductions, thereby becoming a new driver of the declining long-term bond yields.

Fourth, signals from the central bank's governor indicated a further reduction in the reserve requirement ratio and the benchmark reverse repo rate may be forthcoming.

On October 17, during a financial forum in Beijing, PBOC Governor Pan Gongsheng hinted that, based on liquidity conditions, commercial banks' reserve requirement ratios might further be cut by 25 to 50 basis points by year's end, potentially paving the way for additional policy easing measures

He also suggested that the 7-day reverse repo rate might see a reduction of 20 basis points, with mid-term lending facility rates possibly decreasing by 30 basis points to maintain a supportive monetary policy.

Fifth, the market continues to anticipate some fiscal stimulus support early next year.

Despite initial signs of recovery in the real estate market following unprecedented stimulus measures, there have been no significant improvements in economic data after several monthsWithout meaningful fiscal stimulus, the macro economy risks shifting from mild deflation to moderate deflation; the persistent decline in bond yields reflects this economic outlook.

Nonetheless, with increased bond issuance and expectations of additional stimulus measures announced at year-end meetings, the dynamics of the Chinese bond market may change after late December, potentially narrowing further declines in yields.

Why did both onshore and offshore renminbi experience a sudden drop today? Aside from investment funds flowing into the bond market driving bond prices up and consequently lowering yields, there are two additional reasons contributing to this downturn.

Firstly, warnings issued to BRICS nations on Saturday stating that “weakening the dollar’s position will be met with 100% tariffs” bolstered the dollar index.

On Saturday, November 30, posts on social media stated: “We expect commitments from them...neither to establish a new BRICS currency nor to support other currencies that would replace the strong dollar, or they will face 100% tariffs.”

The BRICS members include Brazil, Russia, India, China, and South Africa

BRICS leaders held a summit in Kazan, Russia, in October to discuss enhancing non-dollar trade and strengthening their own currenciesAt that time, the leaders issued a joint statement agreeing to encourage "strengthening the agent banking network within BRICS nations and settle in local currencies per BRICS cross-border payment initiatives."

If the BRICS nations continue with this declaration, any imposition of 100% tariffs by the US would undoubtedly harm these countries' export of goods and foreign exchange earnings, thereby destabilizing their currency valuesConsequently, such rhetoric has reinforced the dollar's strong position, contributing to a 0.61% increase in the dollar index to 106.39.

Secondly, the decline in gold prices also fueled today's weakening of the renminbi.

Typically, there is an inverse relationship between the dollar index and gold prices; currencies that are negatively correlated with the dollar index exhibit a positive correlation

This is because gold is priced in dollars; when the dollar strengthens, the cost of purchasing the same amount of gold requires fewer dollars, leading to a decline in gold prices; conversely, when the dollar weakens, more dollars are needed to purchase the same amount of gold, pushing prices upwardsAdditionally, gold is regarded as a safe haven and a store of value that usually declines in price when economic growth is stable, inflation is mild, and geopolitical dynamics are relatively peacefulHowever, in times of heightened geopolitical tensions and serious inflation, gold prices will trend upwards.

Since the beginning of November, with the dollar index's robust recovery, gold prices have been on a continuous declineOn December 2nd, gold prices dropped by 0.69% compared with the previous trading day.

4. Limited short-term depreciation for the renminbi, with substantial medium to long-term downward pressure.

As for the future trajectory of the renminbi, two phases should be assessed.

Firstly, for December and January, the short-term depreciation potential of the renminbi is limited.

Given the seasonal business settlement mechanisms, the renminbi exchange rate will receive support, with endogenous elasticity enhancing its strength, likely resulting in a relative peak within these two months

The renminbi could fluctuate between 7.2 and 7.3 against the dollar.

Secondly, from February next year onward, there is significant medium to long-term downward pressure on the renminbi.

In China, there are no signs of a policy shift facilitating transformationAll financial stimulus measures remain heavily path-dependent, aligned with a policy inertia that exacerbates structural contradictions between insufficient demand and over-supplyConsequently, every policy primarily targets the supply side, failing to address demand inadequacies, which amplifies the overproduction issueIn such an environment, improvements in the economic basics seem unlikely.

On the international front, not only are the US and European countries imposing tariffs on numerous Chinese products undermining export possibilities, but even the historically close ally, Russia, on December 1, reversed its previous zero tariff on furniture components imported from China to a staggering 55.65%.

This notice was sourced from the official website of the Association of Furniture and Wood Processing Enterprises of Russia (AMDPR). Particularly alarming is that Europe only raised duties on similar Chinese components to 10%, contrasting sharply with Russia's 55.65% tariff hike.

Should our exports contract significantly next year while domestic demand stagnates, the economic stimulus measures we have undertaken will further exacerbate demand-supply contradictions, intensifying deflationary pressures and deteriorating international balance of payments